Impact Of Capital Structure On Financial Performance

A Study Of Public Listed Financial Institution

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CHAPTER 1

1.1 Background of research

Capital structure is the one of the most important concept related to finance that is used by the most of business firms in order to evaluate their business performance. Capital structure is basically a set of liabilities that are currently in the business. All these liabilities comes in two categories equity and liability. The proportion of both in the capital structure greatly affects the financial performance of the business firm. Capital structure can be termed as a means that is usually used to finance business operations (Pratheepkanth, 2011). It is the combination of debt and equity that are usually used to finance business operations. The way in which business operations are finance have a significant importance for the managers. This is because the way of finance determine size of overall finance cost of the business firm. In the current report detail study is carried out on the 10 financial institutions of Jordon and impact that capital structure have on their financial performance. In this regard data related to the relevant firms will be gathered from the books, magazines and journals. In the current research study an attempt is made to identify and understand the impact that capital structure have on the financial performance of the business firm. Detailed literature review will also be done in respect to capital structure and financial performance. It is common assumption among the people that in case if wrong debt equity mix is prepared by the business firm then performance of the firm may severely be affected. Thus, it can be said that capital structure have due importance for the business firms. It is very important to understand the reason due to which capital structure have a very high impact on the financial performance. Finance cost of the business and liability burden depends on the capital structure. If there is a very high amount of debt in the capital structure then in that case burden of interest will be very high on the firm. Suppose firm face loss in its business then in that case also it will have to pay interest to the creditors. So, loss in business and further payment of huge amount of interest will make firm condition pathetic (Margaritis and Psillaki, 2010). Contrary to this, suppose there is high proportion of equity in the debt in the capital structure then also to some extent financial performance will be negatively get affected. This will happened because external entities as shareholder will influence firm decision making. Such kind of thing sometimes severally affect the firm business performance. Thus, excessive proportion of debt or equity in the capital structure negatively affect the business performance. Due to this reason it is very important to maintain balance in the capital structure. If there will be optimum capital structure then burden of finance cost on the firm will be low and there will be high return on equity and asset in the business.

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1.2 Research aims and objectives

The aim and objective of research are as follows.

Aim: To identify the impact of capital structure on the financial performance.

Objectives

  • To evaluate the capital structure and financial performance of the business firms.
  • To identify the impact of capital structure on the gross profit margin (GPM)
  • To identify the impact of capital structure on the net profit margin (NPM)
  • To identify the impact of capital structure on the return of capital employed (ROCE)
  • To identify the impact of capital structure on the return on assets (ROA)
  • To identify the impact of capital structure on the return on equity (ROE)

Research questions

  • What is the nature of the capital structure and financial performance?
  • What is the impact capital structure have on the gross profit margin of the relevant firms?
  • What is the relationship between net profit margin and capital structure?
  • What is the limit up to which capital structure affects ROCE?
  • What impact capital structure have on the ROA?
  • What influence capital structure have on return on equity?

1.3 Rationale of research

Capital structure is the concept on which with passage of time period many research scholars write a lot because it have impact on the firm performance. Capital structure is the factor that play an important role in determining the cost of capital for the business firm and its burden on same (Onaolapo and Kajola, 2010). It is not clear to most of people that what capital structure have impact on the firm business performance. Thus, it was necessary to conduct to research on the impact that capital structure have on the firm financial performance. In order to obtain reliable results firm performance will be measured by using varied ratios like gross profit margin, net profit margin, return on capital employed, return on assets and return on equity. Overall result on these ratios will help one in deriving reliable results.

1.4 Significance of research

There is lots of significance of the current research study. Most of the corporations make a mistake in developing their capital structure. Due to this reason burden of finance cost increased on the business firm. In case of downturn in economy severe impact of imbalanced capital structure is observed on the firms. Current, research study will help readers in identifying and understanding the impact of capital structures on the financial performance. Means that through review of the research report one will come to know about the impact that different capital structures have on the financial performance of the business firms.

1.5 Structure of the report

Introduction

This is the preliminary part of the current research study under which main focus is on understanding the concept of the capital structure and its impact on the financial performance. Rationale and significance of the research is also explained in the report.

Literature review

This is the second and one of the most important part of the current research study. In this section of the report analysis of secondary data is done and on this basis impact that capital structure have on the firm’s financial performance is identified. In this part of research study reliable and relevant research papers will be evaluated and in proper manner interpretation of results of statistical tools will be done to identify the outcome of the previous research studies that were conducted on the capital structure and its impact on the firm financial performance.

Research methodology

Research methodology is another important part of report because under this detail explanation is given about the way in which current research study is carried out. This section will be fragmented in different parts and detail explanation about research approach and philosophy will be given in this part of report. Thus, it can be said that research methodology section is very important component of this report.

Data analysis

In this section analysis of data will be done. Obtained results will be presented with interpretation. In the data analysis section according to research requirement tools and methods are applied on data for analysis purpose. Thus, it can be said that overall result of research will be derived from this part of the report.

Conclusion and Recommendations

It is the final part of the report and on the basis of obtained results conclusion is prepared and recommendations are made at end of the research study.

CHAPTER 2

Literature Review

To evaluate the capital structure and financial performance of the business firms.

According to San and Heng, (2011) there is a very close relationship between the capital structure and business performance. This is because business performance is measured in terms of revenue and profit. It is well known fact that profit in the business depends on the expenditure that are made by the firm in its business. Thus, if expenses are in control profit will goes up in the business. Finance cost cover certain percentage of sales every year. If there is a balanced capital structure then burden of finance cost on the business can be reduced and profit can be increased which ultimately lead to improvement in business performance. To understand that impact of capital structure on the firm performance it is necessary to evaluate two conditions namely balanced and imbalanced capital structure. If there is a balanced capital structure then it means that proportion of debt and equity is almost equal. Hence, there is be less burden of dividend and interest on the business firm. There will be moderate amount of finance cost in the business. Contrary to this, suppose capital structure is imbalanced then two sort of conditions may come in existence either there may be high proportion of debt in the capital structure or percentage of equity may be high on same. In both cases capital structure affects firm performance. This is because in case debt percentage is high firm will be liable to pay huge amount of interest to the creditors even it face loss in its business. In such kind of situation loss faced by the firm will further increased and cash reserved will reduced in the business. Hence, it can be said that such kind of imbalanced capital structure negatively affect the firm performance. On other hand, if there is high proportion of equity in the capital structure then in that case also company may observe poor business performance. This is because high proportion of equity in the capital structure lead to heavy amount of dividend payment to the shareholders. Due to payment of high amount of dividend profit also get reduced. In this way, high portion of equity in the capital structure negatively affects the firm performance. This, proved that imbalanced capital structure have negative impact on the business firm.

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Contrary to this Maditinos and et.al., (2011) state that there is no relationship between capital structure and firm performance. This is because to what extent firm will perform good or bad depends on the market conditions and firm business strategy. If market conditions are suitable and strategy is appropriate then in that case in every condition firm earn profit in its business. In such kind of situation capital structure does not matter. Thus, instead of giving due importance to the capital structure prime significance must be given to business strategy and surrounding environment. Only by doing so any firm can improve its business performance overnight.

In views of Ahmad, Abdullah and Roslan, (2012) any business firm must not give due importance to single factor. Managers must keep eye on business environment, effectiveness of the firm strategy and capital structure. All these factors more or less affects the business performance. Hence, significance of any of them cannot be undermined by the firm. In order to improve business performance managers must focus on multiple factors and must act on all of them altogether. By doing so it can be ensured that company performance in every condition will get improved. There must be proper plan which must be followed keep keen eye on new developments that are happening in the business environment. Like monthly meeting can be conducted between the managers and they can share each other opinion on changes that are happening in the business conditions. By doing so suitable solution of the problem can be identified. Apart from this, while preparing business strategy rivals tactics can be evaluated and best one can be developed for the business firm. This will ensure that firm will be able to deliver magnificent performance in its business. Moreover, at same time to time capital structure can be evaluated by the business firm and it can easily decide whether debt or equity must be used to finance business. Thus, by taking steps in respect to these three variables better decisions can be made by the business firm.

As per views of Ahangar, (2011) there is no appropriate form of capital structure that can be followed by the business firms. Means that it is not possible for the firms to maintain 50:50 ratio of debt and equity. This, is because every business firm have specific sort of capital structure and it may be balanced or imbalanced in nature. While raising fund through any source of finance firm consider number of factors but then also there is a probability of making wrong decisions. It is possible in specific situation that raising a fund through both debt and equity is not appropriate for the business firm. There may be a situation where there is a heavy amount of debt in the business due to which there is a heavy burden of finance cost on business. At same time, there may be a situation where there is high amount of issued equity in the business and above certain level it is not possible to further issue shares in primary market. In such kind of scenario any company have to choose least loss making option. Thus, always it is not possible to maintain optimum capital structure in the business.

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According to Molly, Laveren and Deloof, (2010) since inception of business main focus must be on maintaining balance in the capital structure. If this will be done then it is to some extent possible to maintain balance among debt and equity in the business. If same will be done then business firm can maintain its performance up to specific level. Thus, it is very important to follow best strategy related to capital structure in the business at preliminary stage.

To identify the impact of capital structure on the gross profit margin (GPM)
According to Margaritis and Psillaki, (2010) capital structure and gross profit margin are interlinked to each other. This is because capital structure and gross profit margin are interlinked to each other. Thus, with change in the capital structure gross profit margin also get changed. Capital structure lead to development of finance cost in the business. By this finance cost amount of profit earned on business declined.

  • To identify the impact of capital structure on the net profit margin (NPM)
  • To identify the impact of capital structure on the return of capital employed (ROCE)
  • To identify the impact of capital structure on the return on assets (ROA)
  • To identify the impact of capital structure on the return on equity (ROE)

References

  • Margaritis, D. and Psillaki, M., 2010. Capital structure, equity ownership and firm performance. Journal of Banking & Finance.
  • Onaolapo, A.A. and Kajola, S.O., 2010. Capital structure and firm performance: evidence from Nigeria. European Journal of Economics, Finance and Administrative Sciences.
  • Pratheepkanth, P., 2011. Capital structure and financial performance: Evidence from selected business companies in Colombo stock exchange Sri Lanka. Researchers World.
  • San, O.T. and Heng, T.B., 2011. Capital structure and corporate performance of Malaysian construction sector. International Journal of Humanities and Social Science.
  • Maditinos, D. and et.al., 2011. The impact of intellectual capital on firms' market value and financial performance. Journal of intellectual capital.
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